What exactly is working Capital? In a business it can be defined as its current assets less its current liabilities. Current assets comprise cash, stocks of raw materials, work in progress & finished goods, marketable securities such as Treasury bills & amounts receivable from from debtors. Current liabilities comprise creditors falling due within twelve months, & may include amounts owned to trade creditors, taxation payable, dividend payments due, temporary loans, long term debts maturing within one year & so on.
All businesses needs adequate liquid resources to keep everyday income. It deserves enough to cover wages & salaries as they fall due & enough to pay creditors when it is to keep its workforce & ensure its supplies. Maintaining adequate working working capital is not just important for the short term. Sufficient liquidity should be maintained in order to ensure the survival in the business in the long term as well. Even a profitable company may fail when it does not have adequate income to satisfy its liabilities as they fall due.
Precisely what is Working Capital Management? Make certain that sufficient liquid resources are maintained is a point of capital management. This involves achieving a balance in between the requirement to minimize the potential risk of insolvency and the requirement to optimize the return on assets .An excessively conservative approach resulting in high amounts of cash holding will harm profits because the ability to produce a return on the assets tide as cash will have been missed.
The volume of Current Assets Required. The volume of current assets required will depend on the nature of the company business. For example, a manufacturing company may need more stocks than company in a service industry. As the level of output by way of a company increases, the volume of current assets required will also increase.
Even assuming efficient stock holdings, debt collection procedures & cash management, there is still a specific amount of choice within the total level of current assets necessary to meet output requirement. Policies of low stock-holding levels, tight credit & minimum cash holding might be contrasted with policies of high stock (To allow for safety or buffer stocks) easier credit & sizable cash holding (For precautionary reasons).
Over-Capitalization. If there are excessive stocks debtors & cash & very few creditors there will probably an over investment from the company in current assets. It will likely be excessive & the business are usually in this respect over-capitalized. The return on the investment will be lower than it needs to be, & long term funds will be unnecessarily tide up when they might be invested elsewhere to earn profits.
Over capitalization with regards to working capital should never exist if you have good management but the warning since excessive working capital is poor accounting ratios. The ratios which can help in judging if the investment linrmw working capital is reasonable are the following.
Sales /working capital. The amount of sales as a multiple of the working capital investment should indicate weather, when compared with previous year or with a similar companies, the complete value of working capital is just too high.
Liquidity ratios. A current ratio in excess of 2:1 or perhaps a quick ratio greater than 1:1 might point to over-investment in working capital. Turnover periods. Excessive turnover periods for stocks & debtors, or a short period of credit taken from supplies, might indicate that this amount of stocks of debtors is unnecessarily high or even the amount of creditors too low.